When a person makes an investment in an asset, it is logical that they want to know the profitability that they will receive with such investment, which will allow them, on the one hand, to know how much their wealth increases and, on the other hand, to make comparisons with other possible investments.
There are different profitability measures, depending on the situations considered:
- Internal rate of return (IRR). An example is given below to illustrate this concept: A company is awarded a license to manage the use of a specific toll road. When making its financial forecasts, the company will have an estimate of income and expenses throughout the term of the license. How to determine the profitability of this transaction? In this type of situation, a large amount of income and expenses are produced at multiple moments in time, which therefore cannot be considered homogeneous. To make a homogeneous comparison, every capital must be moved at the same moment in time (for example, the origin of the transaction). For a given interest rate with which to carry out such translation, three different situations can arise:
- The value of the sum of the income carried to the initial moment exceeds that of the expenses.
- The value of the sum of the income carried at the initial moment is less than that of the expenses.
- The value of the sum of the income carried at the initial moment is equal to that of the expenses.
Therefore, the interest rate for which this last situation occurs is called the internal rate of return (IRR), being the one that equals the flows or streams of income and expenses of a financial transaction. It indicates the profitability that is achieved if the investment project is carried out.
That said, to correctly interpret the concept of IRR, it must be borne in mind that an interest is being computed in the calculations performed. For example, if a project involves an initial expense of 100 c.u. and a future revenue of 200 c.u. two years from now, the IRR makes the two amounts equal at the same point in time. In other words, a 100 c.u. outlay with a return equal to the IRR equals to 200 c.u. capital two years from now.
If a project has an IRR of 10% and by investing in the market in financial assets, a return of 6% can be achieved for the same period, it means that the project is interesting: It allows receiving a higher return than that of the alternative investment.
In short, to judge the profitability of a project, its IRR must be compared with the profitability rate that can be achieved in alternative investments.
The IRR concept may seem straightforward, but the calculation can be quite time consuming if you don’t have the right tools, such as spreadsheet software or a customised financial program.
